INVESTMENT FOCUS-Herd scatters again as correlations weaken

LONDON, April 5 The investment herd is
scattering again in a sign of less stressful times, encouraged
by resolute central bank protection even if scarce growth and
jobs may deter funds from straying too far.

One of the defining features of the crisis of the past six
years has been hyper-correlation of global markets - where
assets as diverse as equities and commodities, high-yield debt
or emerging markets moved in lockstep as fears for the stability
of the global financial system ebbed and flowed.

Investment decisions everywhere became binary, captured by a
dominant swing between 'risk on' or 'risk off', or RORO for
lovers of acronyms, on developments as far afield as Athens,
Beijing or Washington.

The metronome looks to have broken down in 2013 however.
Investors appear convinced by 2012's open-ended commitment from
the world's three biggest central banks to do 'whatever it
takes', in European Central Bank chief Mario Draghi's phrase, to
stabilise financial systems and reflate depressed economies.

The Bank of Japan's super-sized boost to its yen-printing
asset purchases this week was just the latest instalment.

Just how far the tone has shifted is illustrated by the way
different assets and national bourses are now trading on their
idiosyncratic merits, valuations, or problems rather than
riffing off each other on overarching global concerns.

What's more, events such as February's inconclusive election
in Italy or last month's messy Cyprus bailout stirred only minor
ripples across world markets which just a year ago would
probably have stampeded investors toward exits across the globe.

But the pattern has broken down everywhere. Wall St's
nine percent gains to record highs or Tokyo's 21 percent
stocks surge while the yen plunged stands in contrast to net
flat euro zone equities, or a 2 percent drop in emerging market
stock indices or about 5 percent losses in commodities and oil.

Unlike recent years, there's no one overarching narrative or
theme driving these moves - beyond a generalised reduction in
stress and volatility.

Crunching the data shows cross-country equity correlations
over 24 countries fell to their lowest since late 2008 in the
first quarter while high correlations between the euro/dollar
exchange rate and other equity, bond and commodity asset groups
were at their lowest in about two years. (See graphics)

"We're seeing a much bigger dispersion of returns this year,
certainly within the likes of emerging markets, and people are
more willing to latch on to national stories or policy
directions," said Percival Stanion, who runs more than 8 billion
pounds ($12 billion) in multi-asset strategies for Barings Asset
Management.

"For us 'risk-on, risk-off' ended last summer with Draghi's
euro pledge that broke the link between banking collapses and
euro survival," said Stanion, adding "whatever it takes" policy
tilts from governments everywhere would only increase as a lack
of growth and jobs becomes a serious electoral threat.

Other funds echo that, with Edinburgh-based Standard Life
Investments saying this week it was examining more individual
country risks as policy responses vary from economy to economy
and building more currency themes into multi-asset portfolios.

"There are strong signs that the binary 'risk on-risk off'
environment of 2011-12 is starting to mutate as the worst tail
risks fade," said SLI economist Douglas Roberts.

Credit Suisse strategists said the way markets shrugged off
euro zone risks in the first quarter marked a "profound change"
in sentiment. "We feel that the gradual 'normalisation' of
investment flows seen over recent months is set to continue."

JUSTIFYING DIVERSIFICATION

For the big institutions who believe broad diversification
of pension, insurance or endowment portfolios across many assets
and countries is the best and safest long-term strategy, high
correlations of the past six years have been a disaster.

These exaggerated the countervailing dash for 'safe assets'
over the period and also accelerated demand for less correlated
'alternative' assets such as private equity or hedge funds or
real estate and infrastructure.

A sustained easing of correlations now may well tempt them
back to more traditional risk assets like equities, even if
conservative funds will be slower to declare that the coast is
clear and will want to see far more "normalisation" first.

"De-correlations will help equities but it is not a
game-changer," said Lars Kreckel, Global Equity Strategist at
Legal & General Investment Management.

What's more, HSBC strategists, whose 'RORO' index on
cross-asset and cross-border correlations fell sharply in the
first quarter back toward late 2008 levels, are also reluctant
to sound the all clear just yet.

The bank's quantitative analyst Stacy Williams points out
that there have been at least three false dawns like this since
2008 where the index has bounced back sharply again. And at the
end of March, it still remained far above pre-2007 averages.

Williams stressed that low volatility in key drivers such as
U.S. equities was an important aspect of weakening in
correlations and had amplified idiosyncratic behaviour in other
assets. As a result, the key test of a return to more normal
conditions would be how correlations reacted to any sharp jump
in market volatility itself and the jury was out on that, he
said.

"Everyone probably wants the 'risk on/risk off' world to end
because they're bored or frustrated by it and want to get back
to using their expertise in specialist areas," said Williams.
"But I think everyone also knows this could all return again
pretty quickly."

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